Investing in DeFi is easy, but this is not the case for everyone. Beginners struggle so much with basic crypto concepts that DeFi features only bring additional headaches. Let's change that by showing you how to invest in DeFi in the simplest way possible.
There are only two types of people who have not heard about DeFi: those living under a rock and hardcore Bitcoin maximalists. As long as you have an internet connection and access to Crypto Twitter, you have most likely seen at least one soul talk about decentralized finance.
DeFi is not just a niche that reached fame after a particularly critical time in the crypto market. Rather than that, DeFi is another step in the evolution of digital assets that seeks to institutionalize an important cornerstone of blockchain cuisine: decentralization.
With the technology that we have today, there is no reason for centralized finance to exist. As such, many crypto enthusiasts have supported the rise of the DeFi market. After all, who would not want to support a movement that completely removes bureaucracy and intermediaries?
So, what is the hype all about and how can complete beginners join the new market? Be cautious, let’s not rush into this. Before we show you how to invest in DeFi, we will first showcase the segment’s importance and all the risks that the market carries.
What is decentralized finance (DeFi)?
Decentralized finance is a subsegment of the cryptocurrency market that deals with, as the name implies, decentralized financial instruments. You’ll find anything from cash instruments and derivative instruments to investment vehicles in DeFi, with the core difference being that they are decentralized as opposed to what TradFi offers.
DeFi turns traditional finance obsolete by offering financial services without the intermediaries that you would usually encounter, like brokers and banks. You can do everything unimaginable in real life, like taking a loan on a Sunday night without collateral or trading on an exchange while still holding crypto assets in a personal wallet.
All of this is made possible with the help of smart contracts and the Ethereum network. In DeFi, every action is processed by such self-executable contracts, and they are commanded solely by the user, without any central entity imposing its influence or will.
Is DeFi safe to invest in?
The DeFi market bears a candid resemblance to ICOs, a similar craze powered by the Ethereum network a few years ago. For everyone who was there to experience the euphoria, it is obvious how investing in cryptocurrencies came close to being synonymous with gambling.
In 2021, we are in a similar situation. New projects are created each day, and there is a gigantic supply of anonymous developers claiming to be Solidity experts. Truth be told, some projects end up reaching greatness and changing the trading scene forever. Sadly, the number of such projects is scarce.
The brutal reality is that most DeFi projects are outright scams. Anonymous individuals often fork other projects or create a dummy cryptocurrency through an ERC-20 generator. After carrying out mischievous marketing tactics, these projects attract naive investors and steal all their money.
The aforementioned malicious activity is so rampant in the DeFi market that the community has coined a name for the activity: rug pulling. You invest in a food-named token, and only a few hours after being listed on Uniswap, the project’s creators pull the rug and take all of the liquidity for themselves.
Our point is not to scare you off or to discourage you from participating in the DeFi market by explaining this phenomenon. Rather than that, we wish to show you just how tricky it is to take part in a market where everyone’s actions are shielded by anonymity.
After all this talk, let’s finally answer the real question: is DeFi safe to invest in? It depends on who is asking. DeFi is definitely a secure market for veteran cryptocurrency traders who know how to get around and understand the industry’s culture. For beginners, it may take several rounds of trial and error in order to understand what works and does not work.
Beyond scams: Technical risks
Trust is not the only risk vector when investing in the DeFi market. It is for sure the most important one, but there are other factors that are much tougher to wrap your head around.
In the case of staking, there is one significant risk: time-locks. If you want to earn an interest rate by contributing your assets for the safety of a DeFi project, you will have to lock your assets for a particular time. Let’s say that you stake DeFi tokens for a juicy 20% APY for a full year. If the market takes a dramatic shift and prices begin to plunge, you will be unable to unlock your assets and sell them.
When it comes to yield farming, users encounter the risk of impermanent loss. If an asset becomes increasingly volatile and loses or gains too much value in a short time frame, you will suffer impermanent loss. What does this mean? If the asset pumps 100% and you were providing it as liquidity during that time, you would have been more profitable if you simply held onto the assets. Think of it as an opportunity cost.
Smart contracts are another risk vector that we take for granted. If you are yield farming or loaning assets and the smart contracts holding your assets get exploited by a hacker, you will lose all of your money. This is the only type of risk on which you cannot take any actions since the exploitability of a smart contract depends solely on the developer creating it.
Great and profitable investors must understand all of these risks in order to stay solvent. Do not take these risks lightheartedly or believe that they will never happen to you.
DeFi vs Crypto
Should you invest in DeFi, or should you stick with legacy crypto altcoins instead? There is life beyond the Ethereum ecosystem as well, so it should not surprise you that there are many other investment opportunities besides decentralized finance. But let’s see if DeFi is better than crypto or not.
According to market data from DeFi Pulse, decentralized finance hosts $35 billion in collateralized assets at the time of writing. For most, this is a strange fact considering that this niche market was once worth only $1 billion. Has the industry perhaps changed that much in the course of a year?
Crypto is a market that evolves fast and changes trends by the month; there is no doubt about that. But those traits bring problems of their own. When new trends arrive so frequently, how can we distinguish long-term trends from short-term fads?
We have previously noted that DeFi bears similarity to ICOs. However, we also wish to point out that DeFi stood the test of time and lasted for far longer than anyone has expected.
How to Invest in DeFi: three popular methods
There are a number of ways to make money in DeFi. Instead of choosing one method and forever forgetting about everything else, we recommend that you experiment with all three. That way, you can see for yourself if there is a special strategy that suits your psychology and personality type.
1. Trading DeFi assets
The number one method in this market, based on overall profitability, is trading or investing in DeFi assets. Users can trade on non-custodial decentralized exchanges like Uniswap, SushiSwap, and Bancor for either long-term or short-term holds.
Most people invest by buying low and selling high if such an opportunity arises and market conditions are clear. Due to their low market cap, DeFi assets often double or triple in value over a short time frame. This makes them the perfect assets for drastically multiplying your portfolio.
Other users prefer to get in early on a recently launched project. Those who understand how smart contracts work and can easily determine if a project is legit or not simply by reading these contracts can make a living by differentiating good projects and scams. In this case, the reward is far larger since investors pay presale prices for tokens that will increase 5 to 10 times once they are listed on Uniswap.
Last but not least, we have a group of day traders who constantly purchase and sell tokens at the slightest profit margins. A 20% price increase is enough for these people since they are looking to replicate their success at least a few times throughout the day.
As you can see, trading DeFi assets is much more complex than simply buying and selling a token. There are many trading styles out there, and it is up to you to find out which one suits you the best.
2. Yield farming
Are you a fan of passive income? For some, there is nothing better than earning money without having to do anything. In the world of DeFi, the easiest way of having that fun is yield farming.
Yield farmers make a living by providing liquidity in the form of crypto assets to a decentralized exchange. The DEX uses this liquidity to execute orders created by token swappers, who pay fees. Based on their contribution, yield farmers earn a portion of these fees.
The goal of a yield farmer is to participate in a liquidity pool with the highest yield. They often hop from one liquidity protocol to another in hopes of finding the best rates possible. You might also want to maximize your profits by searching for the best strategies, but there is still money to be made just by depositing your assets in a Uniswap LP and forgetting about them.
3. Earn interest on a lending protocol
Lending protocols are decentralized loan platforms where borrowers and depositors interact with each other. While one group supplies liquidity for the sake of earning interest rates, the other group takes the liquidity in the form of a loan and pays interest.
Lending platforms like Aave offer both variable and fixed interest rates. Variable interest rates constantly change interest based on the asset’s demand. On the other hand, fixed interest rates retain the same rate under all market conditions.
Here is a tip: you can use variable interest rates on Aave in a bull market to maximize your profits. Once a bearish phase hits the market, switch to fixed interest rates and stabilize your income.
Final Word: Should you invest in DeFi?
The world of decentralized finance is a tricky one. Users can make tons of cash overnight but they can also liquidate their entire portfolio in a split second. The risk might be high, but the number of opportunities is far higher.
As a young market, DeFi still has to make a name for itself and cement a clear position. Will it be a safe and secure playground for decentralized projects, or will it continue with harboring malicious actors such as scammers and hackers?
The choice will be made by no one else than the community. At the current rate, DeFi will most likely retain the state of crypto’s wild west, much like ICOs were in 2017. Nevertheless, the niche market will mature throughout the following years once euphoric investors die out and discover that 1000% APY rates are unsustainable.
To conclude: should you invest in DeFi? We cannot really answer that question in your stead. It would be foolish not to advocate the segment given its vast range of opportunities and innovative features. Still, we urge you to heed our warning: do not trust everyone and think twice before investing in a project - or it might be your last investment.